Neoclassical and Behavioural Economics: It Takes Two to Tango

The billion-dollar question is whether neoclassical & behavioural economics will marry or sulk in different corners!

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With the Nobel Prize in Economics being awarded to two prominent behavioural economists, Daniel Kahneman and Richard Thaler, economics will never be the same again. By bringing psychology and emotion to the forefront of economics, behaviorists have made economics beautiful. Yet as is true of any human, the field cannot survive just on the basis of love, beauty and fresh air.

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It would indeed be a pity if we were to sacrifice the rigour of neoclassical economics to embrace the beauty of the behaviorists. After all, neoclassical economics does present a concrete methodology for first characterising the individual consumer (demander) and firm (supplier), and then using this characterisation to work all the way to outcomes at the level of the economy.

Demystifying Neoclassical Economics

Let me remove a common misconception about neoclassical economics. It is not an ideology. All that it assumes is that human beings are goal-oriented, that is, they take actions to reach their goals. Different neoclassical models define these goals differently and then combine those goals with assumptions about cognitive powers, accuracy, extent of foresight, etc. Neoclassical economics is capable of accommodating the altruism of Gandhi as well as the selfishness of Ayn Rand, as is illustrated by the works of James Andreoni.

It is true that the bulk of neoclassical models have concentrated on issues that are material, tangible and measurable. These also assume that individuals are individualistic, that is, they basically care about themselves. It is very important to distinguish between ‘neoclassical methodology’ and the stock of ‘neoclassical models’ with the latter just illustrating how the former has been used.

An analogy would be the criticism of Facebook versus the criticism of its use. If one successfully makes a case for banning Facebook then we shall next be talking about banning books as both are tools of communication which can be used for repugnant causes.

As in the case of Facebook, the future of economics lies in fine tuning neoclassical methodology to address behavioural concerns. I have started devoting some of my research to this endeavour and I am sure others in different parts of the globe are racking their brains too. A concrete example is the idea of ‘sunk costs’: for example, the unbreakable promise you make to pay as soon as you pick up a plate at an expensive restaurant buffet.

Reconciling Neoclassical Methodology & its Behavioural Critique

According to neoclassical models built till date, this promise really should not make any difference to how much we eat! That is, it is rational to let bygones be bygones: an additional morsel of food is ingested as long as it brings positive functional satisfaction, either in terms of yielding pleasure for your taste buds or diminishing your hunger for more. When an additional morsel does not do any of these things, you stop eating. Yet, repeated experiments show that the magnitude of the promise does make a difference to how much you eat at a priced buffet!

The trick lies in broadening the concept of ‘satisfaction’: every morsel of food now not only provides functional satisfaction but also provides psychological succour in the sense that it helps to remove the guilt of under-utilisation of expenditure. It is quite possible therefore, for one to continue eating after functional satiation has been achieved. This would not happen in the case of a free buffet as the ‘guilt factor’ is missing.

The above is only one of the many ways in which neoclassical methodology and its behavioural critique can be reconciled. Therefore, it is possible to think of a marriage between neoclassical and behavioural economics such that economics as a field becomes more beautiful, more humane but not at the expense of precision.

This is akin to a marriage between an artist and a mathematician which results in an offspring who is not only capable of doing both art and mathematics but is able to make full use of their complementarities. In the modern urban world, couples date even before marriages are ‘arranged’. The billion dollar question is whether neoclassical and behavioural economics will date or sulk in their respective corners!

(The author is a Professor of Economics, Jadavpur University, Kolkata. This is a personal blog and the views expressed above are the author’s own. The Quint neither endorses nor is responsible for them.)

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